Question

Brandon is an analyst at a wealth management firm. One of his clients holds a $5,000 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table:

Stock	Investment Allocation	Beta	Standard Deviation
Atteric Inc. (AI)	35%	0.750	53.00%
Arthur Trust Inc. (AT)	20%	1.400	57.00%
Li Corp. (LC)	15%	1.200	60.00%
Baque Co. (BC)	30%	0.500	64.00%

Brandon calculated the portfolio’s beta as 0.8725 and the portfolio’s expected return as 8.80%.

Brandon thinks it will be a good idea to reallocate the funds in his client’s portfolio. He recommends replacing Atteric Inc.’s shares with the same amount in additional shares of Baque Co. The risk-free rate is 4%, and the market risk premium is 5.50%.

According to Brandon’s recommendation, assuming that the market is in equilibrium, how much will the portfolio’s required return change? (Note: Round your intermediate calculations to two decimal places.)

0.37 percentage points

0.60 percentage points

0.55 percentage points

0.48 percentage points

Analysts’ estimates on expected returns from equity investments are based on several factors. These estimations also often include subjective and judgmental factors, because different analysts interpret data in different ways.

Suppose, based on the earnings consensus of stock analysts, Brandon expects a return of 6.82% from the portfolio with the new weights. Does he think that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued?

Overvalued

Undervalued

Fairly valued

Suppose instead of replacing Atteric Inc.’s stock with Baque Co.’s stock, Brandon considers replacing Atteric Inc.’s stock with the equal dollar allocation to shares of Company X’s stock that has a higher beta than Atteric Inc. If everything else remains constant, the portfolio’s beta would ?????   and the required return from the portfolio would ????

Answer 1

Answer-I(Change in Portfolios Required rate of return)

As per CAPM or capital asset pricing model,

Required rate of return =

Rf = risk free assets.

The Existing portfolio has Beta of 0.8725.

Rf= 4%

Market risk premium = 5.5%

Hence Required rate of return for the Existing Portfolio = 4% +[0.8725*5.5%] =8.80%

Revised Beta of the portfolio will change due to change in weights.

Beta of the Portfolio =

Calculation of revised Beta
Stock	Weight	Beta	Weight* Beta
Atteric Inc. (AI)	0%	0.75	0
Arthur Trust Inc. (AT)	20%	1.4	0.28
Li Corp. (LC)	15%	1.2	0.18
Baque Co. (BC)	65%	0.5	0.325
Total	100%		0.785

Revised Beta = 0.785

Required rate of Return of the Revised Portfolio = 4% +0.785*5.5% = 8.32%

Required rate of return on old portfolio	8.80%
Required rate of return on Revised portfolio	8.32%
Change	0.48%

Hence Correct Answer-(d) 0.48 percentage points

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Answer-Part II

based on the earnings consensus of stock analysts, Brandon expects a return of 6.82% from the portfolio with the new weights. But the Required rate of return on the revised portfolio is 8.32%.Here the Expected return on the revised portfolio (6.82%) is less than the Required rate of return (8.32%).

Hence the revised portfolio is Over valued.

Correct Option-(a)Overvalued.

Note-Required rate of return is also called as Minimum return

Situation	Valuation of asset or portfolio	Decision
Expected return> Required rate of return	Under valued (Because the Asset will give more return than the required rate of return or Minimum raturn)	Buy the asset
Expected return< Required rate of return	Over valued (Because the Asset will give less return than the required rate  of return or Minimum raturn)	Sell the asset or dont buy
Expected return= Required rate of return	Fairly valued	Hold

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Answer-Part III

* Portfolio Beta will Increase. Because due to the replacement of Stock with higher beta in place of lower beta will increase the Weighted average beta.

* Required rate of return will also increase. Becaue Higher the Beta the higher the reuired rate of return as,Required rate of return =